cuPs Agf
POLICY RESEARCH WORKING PAPER 2999
Explaining Liberalization Commitments
in Financial Services Trade
Philipp Harms
Aaditya Mattoo
Ludger Schuknecht
The World Bank
Development Research Group
Trade
March 2003
I POLICY RESEARCH WORKING PAPER 2999
Abstract
Harms, Mattoo, and Schuknecht examine the The empirical results confirm the relevance of the
determinants of market access commitments in authors' model in explaining banking and (to a
international financial services trade in the General somewhat lesser degree) securities services liberalization
Agreement on Trade in Services (GATS). Based on a commitments. The findings imply that those who seek
theoretical model, they investigate empirically the role of greater access to developing country markets for
domestic political economy forces, international financial services must do more to counter protectionism
bargaining considerations, and the state of at home in areas of export interest for developing
complementary policy. countries.
This paper-a product of Trade, Development Research Group-is part of a larger effort in the group to assess the
implications of liberalizing trade in services. This research was supported in part by the U.K. Department for International
Development. Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433.
Please contact Paulina Flewitt, room MC3-333, telephone 202-473-2724, fax 202-522-1159, email address
pflewitt@worldbank.org. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The
authors may be contacted at philipp.harms@uni-konstanz.de, amattoo@worldbank.org, or ludger.schuknecht@ecb.int.
March 2003. (39 pages)
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about
development issues. An obhective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The
papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this
paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the
countries they represent.
Produced by the Research Advisory Staff
Explaining Liberalization Commitments
in Financial Services Trade
by Philipp Harms, Aaditya Mattoo, and Ludger Schuknecht *
Contents
1. Introduction
2. A Model of Endogenous Protection in Financial Services
3. An Empirical Study of Financial Services Commitments
4. Results
5. Conclusions
Tables 2-3
Annexes 1-5
Bibliography
JEL classification numbers: D78, F13, G20
Keywords: Financial services, financial sector liberalization, GATS, endogenous protection,
trade in services
Phihpp Harms, University of Konstanz, Germany (Box D 138, 78457 Konstanz, Germany, e-
mail Philipp.Harms@uni-konstanz.de); Aaditya Mattoo, World Bank (1818 H Street NW, Washington DC 20433,
email: amattoo(a.worldbank.org); Ludger Schuknecht, European Central Bank, (Kaiserstr. 29, 60311
Frankfurt/Main, Ludger.Schuknechtgecb.int).
We would like to thank Rolf Langhammer, the participants of the Kiel International Economic Institute and an
anonymous referee for important comments. Aishah Coulatti, Janet Spettle, Randeep Rathindran and Sudesh
Morarjee provided valuable support. The paper was largely written while Ludger Schuknecht was at the WTO. All
opinions and errors are the responsibility of the authors and should not be seen as the view of their previous or
current employers. All data can be obtained from the authors upon request.
1. Introduction
Even though services have a large share in value-added and trade in most countries, the
literature analysing services trade policies is quite limited. Existing studies focus mostly on
certain theoretical issues (e.g., Markusen, 1989) and on measuring the costs of protection or
identifying the consequences of trade liberalisation in specific services sectors (see Hoekman
and Primo-Braga, 1997 for a survey). There has so far been no attempt to examine the
determinants of services trade policy.
Since a major round of trade negotiations is underway at the WTO, one of the main
objectives of which is to improve market access commitments in services, it seems worthwhile
to ask: what influenced the level of commitments in the past? This paper attempts a first
response to this question by focusing on the agreement on financial services that was concluded
in the context of the General Agreement on Trade in Services (GATS).' While the agreement
evoked wide participation from both developed and developing countries, there were
significant differences between countries in their levels of market access commitments. We try
to explain these differences by highlighting the role of three main factors.
First, we follow the considerable theoretical and empirical literature which argues that
trade policy formation is determined by self-interested politicians granting protection or
liberalisation to special interests (for surveys see Hillman, 1989, Magee, 1997, Gawande and
Krishna, 2002). We present a simple model in which a distributional conflict between the
domestic banking sector and the interest of workers determines the choice of trade policy. A
government's propensity to commit to financial sector liberalisation thus depends on the stakes
and the relative strengths of these interest groups in the domestic political process.2
1 The agreement was concluded in December 1997 and its results came into effect on 1 March 1999.
2 Since in our model wages are proportional to aggregate income, it actually allows two interpretations: trade policy
is determined by the relative strengths of the interests of banks and workers, or by politicians' concerns over special
interest support (from banks) relative to social welfare (as measured by aggregate income).
1
Secondly, we emphasise the importance of international strategic considerations and
show that the possibility of exchanging market access concessions across sectors in the future
may induce countries to withhold liberalisation today. The importance of this dimension in WTO
negotiations has been discussed, for example, by Grossman and Helpman (1995a) and Hillman
and Moser (1996), and it seems particularly relevant to the financial services sector: the GATS
agreement was concluded in a separate single-sector negotiation which continued after the
conclusion of the Uruguay Round, and participants must have had a reasonable expectation of
future multi-sector negotiations. Moreover, the incentive to trade off current gains from
unilateral liberalisation against even larger gains from reciprocal opening in the future would
seem to be most important for countries that faced high protection in their areas of export
interest and possessed, alone or as a group, sufficient negotiating leverage to extract
liberalisation commitments from their trading partners.
There is, in fact, some evidence that developing country members of coalitions (explicit
and implicit), like the Caims group of agricultural exporters and the group of developing
countries which faced quantitative restrictions on their textile exports under the former Multi-
Fibre Agreement, were reluctant to open their financial markets in the WTO negotiations. The
absence of an own export interest in financial services was frequently cited as a reason for these
countries' grudging participation in the negotiations as well as for the fact that the GATS
comnuitments sometimes turned out to be even more restrictive than past practice (Mattoo,
2000).3 This reluctance to liberalise contrasts with the fairly liberal commitments made by more
developed countries, which either had an export interest in financial services or already open
domestic markets. It also contrasts with the commitments of several Eastern European countries
which had already made deep market-opening commitments as part of their WTO accession
For example, India issued 15 licenses every year for new foreign bank branches, but committed under the GATS
to issue only 12 new licenses; the Philippines allowed up to 60 percent foreign ownership but promised only a
maximum of 51 per cent. The major sticking point in the negotiations with several other countries, like Brazil,
Indonesia, Malaysia, Pakistan and Thailand, was not the degree of liberalisation they would undertake, but whether
they could be induced to commit to the status quo. Eventually, these countries promised to protect the rights of
2
negotiations, and with the policy of several small countries which were not part of any export
coalition and presumably had little reason to delay liberalisation.4 These observed differences
suggest that, ceteris paribus, the persistence of financial services protection can be explained by
membership of a coalition seeking improved access in heavily protected areas in other countries.
Finally, in an area like financial services, a government's decision to liberalise may be
affected by the economic environment, particularly the degree of macroeconomic stability and
the quality of prudential regulation. The relationship of liberalisation with these two variables is,
however, not obvious. For example, the East Asian financial crisis, during which the financial
services negotiations were concluded, revealed conflicting views. On the one hand,
macroeconomic instability and regulatory inadequacies were seen as a legitimate cause for a
government to hesitate to liberalise. It was argued that, at the very least, weaknesses in
complementary policy create increased uncertainty about the consequences of greater openness,
which in itself is likely to inhibit a risk-averse government.5 On the other hand, it has been
argued that liberalisation should be seen as part of the remedy for these problems and not be held
hostage to their resolution, i.e. the presence of foreign banks could be a stabilising factor and
help improve the regulatory environment (Claessens, 2002, Barth et al., 2000b and 2001).6
Our aim is to investigate whether the forces outlined in the preceding paragraphs had a
significant impact on countries' willingness to commit to financial sector liberalisation in the
GATS negotiations. To this end, we proceed as follows: the next section presents a simple model
of endogenous trade policy with respect to financial services and formally derives hypotheses on
the determinants of financial sector liberalisation. In the second part, we test the model's
hypotheses, using indices on financial services protection that are based on countries'
commitments in recent GATS negotiations. We find that banking services liberalisation and to a
foreign financial institutions already established in these markets - e.g. by not fully implementing the indigenisation
program in Malaysia - but did not provide improved access for new firms.
Note, however, that the distinction between country groups is not that clear-cut. Hence, countries like Australia,
Canada, New Zealand, Poland, and Romania were also members of bargaining coalitions.
The Malaysian response to the crisis, in terms of restrictions on capital mobility, may have reflected this view.
3
somewhat lesser extent securities related services liberalisation is explained well by our
theoretical framework. Greater financial sector development and a high degree of unionisation of
domestic workers are positively correlated with liberalisation commitments. The possibility for
a country of exchanging concessions across sectors in future leads to a more protectionist
regime today. In addition, the study confirms that a greater propensity to make liberalizing
commitments is correlated with greater macroeconomic stability, better prudential regulation,
and greater existing market penetration by foreign firms. The presentation of our empirical
results is followed by the study's conclusions. Several appendices describe the construction of
our financial sector liberalisation indices and provide the sources and properties of the data we
used.
2. A model of endogenous protection in financial services
There is a large literature which argues that financial sector liberalisation improves the allocation
of capital by enhancing competition among banks, reducing transaction costs for foreign trade,
and reinforcing the dissemination of information and skills.7 In this paper, we restrict our
attention to the pro-competitive effects of reduced protection in the financial services industry.
Even though this narrow focus excludes some important aspects of trade in financial services,
our framework will enable us to present some key arguments simply and transparently.
2.1 The economic framework
2.1.1Firms
We consider a small open economy which is specialised in the production of a single traded
good, but consumes a basket of goods and services whose world-market price is normalised to
6 The Korean liberalisation during the cnsis, ending the restrictions on foreign presence, as part of the adjustment
program negotiated with the IMF, may have reflected this view.
4
one and used as the numeraire.8 In every period, the representative domestic firm uses the Cobb-
Douglas technology
Y =Sa , (1)
where St and Lt represent the amount of financial services and labour used in period t. We
assume that labour supply is fixed and normalised to one and that the labour market is perfectly
competitive.
The firm sells its good at an exogenous world market price y,, which is affected by the
(implicit or explicit) trade barriers imposed by foreign countries. Without loss of generality we
assume that, under free trade in goods, the price of the export good equals one, while it is
smaller than one if domestic exporters face foreign protection.
Financial services are provided at a price pi, and the firm's profit-maximising demand for
such services is given by
SI = (ay, I p1 )-l,a (2)
which implies that the elasticity of the demand for financial services is 1/(1 - a). The
equilibrium wage rate is
W, (Y,, p, ) = (1- aX, )I1(l-a)( / )a/(l-a) (3)
which is obviously increasing in y, and decreasing in pi.
7 For more detail, see Claessens et al. (2001), Claessens and Glaessner (1997), Finger and Schuknecht (2001),
Francois and Schuknecht (1998), Kono and Schuknecht (2000), Buch (1997), and Levine (1997).
5
2.1.2 Profits and wages with a protected banking sector
We assume that there is one domestic provider of financial services ( a "bank") who faces
constant average costs c < 1.9 If foreign banks are not allowed to compete on the domestic
market the bank charges the profit-maximising price p1 = c / a, which generates the profit
nI (y, ) = (1-aXa y, )lI(1 a) (a / 4)aI(-a))
where the superscript "M' refers to the case that the bank has monopoly power. It follows from
(3) that the wage rate associated with a monopolistic banking sector is
wm (r, )= (1 - a)(y, )I(,-a)/aa(1-ca)(a/C)a/(l-a) (5)
2.1.3 Profits and wages with free trade in financial services
If the government allows foreign banks to enter the domestic market, the bank loses its
monopoly position and has to adjust its pricing behaviour to the fact that it faces foreign
competition. We assume that, due to better access to information, existing networks etc., the
domestic bank has a cost advantage on the domestic market, and that foreign banks produce
financial services at constant average costs CF = 1. As a result, the maximum price the domestic
bank can charge after liberalisation isp = 1, which yields the profit
nlc (Y,) = (I - cXay, )I(1-a) (6)
8 We assume that this basket consists of a continuum of goods and services. Hence, small changes in the price of
one good do not affect the value of the basket.
9 Alternatively, we could assume that there are several domestic banks who coordinate their pricing behaviour.
6
where the superscript "C' refers to the fact that free trade results in competition among banks.
We assume that c > a, i.e. that the monopoly price is greater than one. Hence, the bank's profit
decreases as a result of financial liberalisation. The wage with competition in the banking sector
is
w, (y, )=(-aXy, )"/"-a)a/(li-a) (7)
Since c > a it holds that wC > wM for a given value of y,: if there is competition in the banking
sector, the price of financial services decreases, which raises the firm's demand for these services
and thus the marginal product of labour and the wage rate. Hence, while the bank would like to
prevent foreign competitors from entering the domestic market in order to maintain its monopoly
power, domestic workers would benefit if firms had cheaper access to financial services.
2.2 Time structure and choice of trade policy
We assume that in period 0 the government participates in negotiations on financial sector
liberalisation which are not associated with negotiations over trade policies in other sectors. The
government seeks to maximise the "political support" it receives from domestic workers and
from the domestic bank, and makes its liberalisation choice accordingly. For simplicity we do
not explicitly model the international negotiating process but rather treat the domestic
government's decision as a unilateral step. As justification for this simplification, we note that
the domestic political support function describes the payoffs that ultimately determine the
government's behaviour in negotiations.
Both workers and the bank have an infinite time horizon. While workers' support rises in
the expected present value of wages, the bank's support increases in the expected present value
of its profits. Specifically, we assume that the political support in period 0 is given by
7
V ,= :t{ .5'Eo(w,)] ZO.EO(1, (8)
where Eo is the expectations operator. The exogenous weight w reflects the relative political
impact of workers, which depends on the two interest groups' willingness to spend resources on
lobbying, on their ability to overcome problems of collective action etc.10
The concept of a "political support function" goes back to Peltzman (1976) and is used
by Hillman and Moser (1996) and Grossman and Helpman (1994, 1995a, 1995b) in their
analysis of trade policy. Grossman and Helpman (1994) present a sophisticated derivation of a
reduced form similar to a static version of (8), which is based on the notion that incumbent
governments maximize the sum of financial support they receive from special interest groups,
but also take into account the effects of their policies on social welfare. In our framework, the
maximisation of wages coincides with the maximisation of aggregate income. Hence, the first
part of the political support function in (8) may also be interpreted as reflecting the govemment's
concern for social welfare.
If the government commits to liberalise trade in financial services in period 0, foreign
banks will immediately enter the domestic market and competition will drive the price of
financial services down to one in the current and all future periods. On the other hand, if the
government does not commit in period 0, it may enter another round of negotiations at some
later date. Our crucial assumption is that future negotiations over financial services trade will
possibly be linked to negotiations over trade in other goods and services. This implies that in the
future the domestic govemment may exchange a commitment on financial sector liberalisation
against foreign market liberalisation for domestic exporters, raising the world market price of the
domestic good to one. Without modelling the details of future negotiations we assume that the
iC The choice of a discount factor of 0.5 will later simplify the algebra, but is not crucial for our results.
8
probability of such a successful exchange of market access in any future period is q, the
magnitude of which depends both on the domestic government's bargainnmg power and the
political objectives of foreign governments.
It is easy to show that the political support the government gets if it liberalises in period 0
at the prevailing world market price of ro is given by
VL (70) = 2 [a) wc (r0) + rIc (0) ]. (9)
On the other hand, the political payoff from not liberalising is
VN (0)=WwM(70)+nM(70) (10)
+ 0.5{q * max[VL(1), VN(to)]+ (1- q). max[VL(o) VN(yo)]}.
The term in curly brackets reflects agents' anticipation that a government that does not liberalise
today may still choose to do so tomorrow, maybe on better terms. Comparing (9) and (10), we
can derive a condition that is both necessary and sufficient for making the government prefer
liberalisation at t = 0:
as {Wc (O )-Wm (to) )-q [wc( )wc (yo)] }~ 2 Im (yO) )-rI (yo ) + q [rIc (l )-Il (yJ ] * ( l l)
The LHS in (11) reflects the trade-off faced by domestic workers: while they benefit
from immediate financial liberalisation, the combination of a competitive financial sector with
less protection for domestic exporters would represent the best of all worlds for them, since both
the higher output price and the lower price of financial services increase the real wage. The
negative term on the LHS of (11) demonstrates that this reduces workers' interest in immediate
9
financial sector liberalisation. On the other hand, the prospect of linking financial liberalisation
to a price increase of the export good reinforces the domestic banks' resistance against the
immediate removal of entry barriers. This is shown by the second term on the RHS of (11),
which is unambiguously positive.
Defining tV = (I - YO (a) and using (4) - (7), one can show that the condition in
(11) is equivalent to
w a (a I - v q_ - C(a I(1-a) - ) (12)
if q< ,with qc
If q 2 q, workers weakly prefer ongoing protection because there is a high likelihood that a
successful exchange of market access will raise wages in the future. As a result, the LHS in (11)
is zero or negative, and, regardless of co, the government refuses to conunit to financial sector
liberalisation in period 0. This demonstrates that even if the government's sole objective were to
maximise workers' expected wages (or social welfare), it would nevertheless refrain from
immediate financial sector liberalisation given that the payoff from keeping protection as a
bargaining chip in future negotiations was high enough. On the other hand, if q < ¢, the LHS of
(11) is strictly positive and the government decides to commit to liberalisation in period 0 if the
workers' weight in the political support function is not smaller than the threshold value a, as
defined by (12).
2.3 Comparative static analysis
In this subsection, we will analyse how variations in the model's parameters affect the threshold
10
value &.
If there is no chance that domestic market access for foreign banks will be exchanged
against foreign concessions for domestic exporters in the future (that is, q = 0 ), the condition for
financial liberalisation in (12) reduces to
O- 1a II- a) (a / C)a111-a) - (I - c)] Cb(13)
(i - a)[1 _ (a/ C)a II~I-)j (3
The following proposition summarises how 6 as defined in (13) reacts to changes in the
domestic banl's marginal costs c.
Proposition 1: With c > a and q = 0, the minimum relative weight of workers that is necessary
to induce the domestic government to commit to financial sector liberalisation in period 0 (6)
increases in c.
Proof: Taking the derivative of 6) with respect to c, one can show that 6) increases in c if
(a/c)I/(Ia) [(a2 _c)/(a -a2)]+1>0. Defining 6- c/a, we can reformulate this condition as
G(a,g5) =(l1/)1/(1-a) [(a 2 _aq)/(aq-a2)]+ 1> 0. It can easily be seen that G(a,l)=O. To
prove that G(a, 0) > 0 for 0 > 1, we take the first derivative of G with respect to q, which turns
out to be strictly positive.
Proposition 1 states that the less efficient the domestic banking sector - that is, the higher
its average costs relative to foreign competitors - the higher the political weight of workers that
is necessary to induce the government to commit to financial sector liberalisation. The intuition
for this result runs as follows: a high value of c reinforces the reduction of the domestic bank's
profit that comes along with financial sector liberalisation. Raising c also increases the stake of
domestic workers, but the first effect apparently dominates. While the influence of c on 6) is
11
unambiguous, it is not possible to determine the effect of variations in a. Lowering the markup
(1/a) by raising a eases the distortion that characterises the closed economy and reduces the
desirability of financial services liberalisation for workers. However, it also reduces the stake of
the domestic bank since, ceteris paribus, monopoly profits decrease in a. Which effect
dominates depends on the levels of both c and a.
The preceding paragraphs considered the effects of varying c and a for q = 0, that is for
the special case that the policy regime determined in t = 0 prevails with certainty in the future.
Proposition 2 considers the case of q > 0 and summarises how the threshold weight of workers
reacts to changes in yr and c:
Proposition 2: For 0< q